The bottom line is that money management will make or break you as a trader. This is a widely accepted fact. Proper money management rules have been proven over long periods of time and are not secrets to anyone. The rules of ‘keeping your trades small’ and ‘cutting losses’ for example, have worked for hundreds of years, yet many people ignore them.
No matter what aims you may identify when first determining what you are setting out to achieve with your trading, all aims are secondary to your primary goal — preserving your trading capital. This is by far the most important aspect of successful trading. Simply stated, you need capital to trade.
‘Trading to survive’ is another way of expressing this primary goal. If you can survive, you can keep trading, and the longer you keep trading, the greater chance you have of success. Most people don’t realize how important it is that you protect your capital and, again, many people are not inclined to think about protecting it. It goes against many of their natural tendencies, as they probably wish to concentrate on the task of making money.
Managing and controlling risk is crucial. In fact, I believe that a failure to respect and therefore manage your risk when trading will ultimately lead to your trading demise. Many people lose a lot of money while trading by failing to understand and manage risk.
A simple explanation for what most people do wrong can be summed up as follows.
Usually, when faced with a losing position, consistently profitable traders become risk-averse and are quick to close the position with a small loss. Most traders, on the other hand, usually become risk-seeking as they hold on and wait for the price to return to near the entry price. This shatters one of the time-tested trading rules of ‘cutting your losses’.
Furthermore, when consistently profitable traders are faced with a profitable position, they become risk-seeking because many of them want to hold out from closing the position for as long as possible to see how far the price goes up. Most traders, when faced with a similar situation, become risk-averse and they are generally quick to close out the position for fear of losing all the profit.
Notice how the acceptance of risk for most people and consistently profitable traders is completely different. Yet, on the surface, most people react to those situations completely naturally. Such feelings are perfectly normal, yet they are feelings that will inevitably cause failure when trading.
Consistently profitable traders have overcome any such natural tendencies and exercise great internal control and discipline. Many people cannot do this and, therefore, are inclined to break the rules.
Now, back to our protecting of our capital. Remember, our primary aim in trading is to ‘Preserve our Capital’.
Basically everyone knows the old saying about not putting all of your eggs into one basket. This rule applies to trading. One of the best ways to manage your risk when trading is to limit or set a cap on how much money you put into a single position. This is to guard against the possibility of something adverse occurring.
This could be represented as a percentage of your capital and, once set, should not be broken, regardless of how confident you are about a particular trading opportunity. It could also be a specific amount in dollars.
Consider this … would you consider committing your entire trading capital into a single trade? I sure hope not. How about 50% of your trading capital? Yes or No? How about 40%?
People do it, however hopefully you realise how foolish this is.
What amount you select will vary depending on the product you trade and the leverage attached.
What we are trying to avoid is a situation where you have the bulk or all of your trading capital committed to a single trade. This is just asking for trouble, and is not a good advertisement for managing your risk.
Remember in the markets, anything can happen and often does - you must do everything in your power to preserve your capital! You do this by spreading your capital out into multiple trades.
There is no right answer here or a ‘hard and fast’ rule. I also believe that the percentage figure you use can be inversely proportional to the size of your trading capital. For example, those with trading capitals over $100,000 for example, have the flexibility of being able to reduce the limit (in percentage terms) they place in a single position, therefore spreading their money out into more trades.
Whereas those with smaller trading capitals may need to be prepared to risk a little more.
Taking this a step further, what about if you are trading different financial products? There are numerous products available to trade including stocks, indices, currencies and commodities. It is critical that you are aware of the specific details of every trade you enter. For example, if you are about to trade 1 contract of a particular index, what is the ‘per pip’ amount for that index?
There is one overriding factor in this calculation – your comfort level. At the end of the day, you MUST be comfortable with how much risk you are taking in a trade. Remember one of the keys to trading success is to have a trading plan that is right for you – this includes your acceptance of risk.
Whilst I have talked about the allocation of capital, one shouldn’t dismiss the importance of exiting trades at an appropriate time too, especially when faced with a losing position.
I will leave you with a quote from one of the traders interviewed in the original Market Wizards book by Jack Schwager – Marty Schwartz. Marty Schwartz’s ability to trade cannot be questioned. Once competing in the US Trading Championships he made more money than all of the other contestants put together in nine out of ten four-month contests, with an average return (non-annualised) of 210 per cent over four months. In another full-year competition, he achieved a 781 per cent return. Staggering numbers by anyone’s standards yet his advice is so simple:
"Learn to take losses. The most important thing in making money is not letting your losses get out of hand."
About Stuart McPhee
Stuart McPhee has traded for over 20 years and is the author of the best selling book Trading in a Nutshell, 4th Edition. He is one of Australia's most compelling speakers on trading and has personally coached high net worth traders all over the world. Since 2001, he has spoken live in front of tens of thousands of fellow traders from Mumbai to New York, Tokyo to London, Melbourne to Beijing, and many places in between. He has helped countless traders improve their performance with his expertise in technical analysis, trading psychology, risk management, the trading process and developing a trading plan.
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